This article is part of EsadeGeo's series on transformational dynamics
There is considerable consensus that climate change will continue to impose deep economic and financial costs on households, communities, and businesses. Savage storms, intolerable temperatures, rising sea levels, and unstable agricultural production are threatening jobs and lives. Catastrophic costs have been mounting, and given the dynamic nature of climate change risks, recent trends may be insufficient to avoid underestimating the scale of potential losses. Such losses will affect all types of business and organisations, as well as damaging some communities more than others. How much and how soon will depend in part on actions taken in the near term.
For financial institutions, physical risks from climate change can materialise directly through exposure to corporations that experience climate shocks and face lower asset values and increased loan default risks, or indirectly, through the effects of climate change on the wider economy and feedback effects within the financial system. What The Wall Street Journal called the first ‘climate-change bankruptcy’ involved fires from Pacific Gas and Electric operations caused by climatic changes that produced prolonged droughts in California.
Direct effects are not limited to corporations because, for example, rising sea levels and extreme weather events can diminish, or even annihilate, property values and endanger mortgage portfolios. More indirect effects are linked to mandated transitions to low-carbon energy, and which could result in what the former Bank of England Governor Mark Carney called ‘literally unburnable’ reserves (the main asset of some oil or mining companies).
Many policies and processes are being refocused to direct resources and behaviour towards a more sustainable economy
To mitigate or anticipate some of these risks, many policies and processes are being refocused to direct resources and behaviour towards a more sustainable economy. Financial regulators in many counties are breaking new ground in this regard and their actions – which can be described under the umbrella term of ‘green finance’ – will have pervasive implications. We also include pressures from financial stakeholders (investors and intermediaries) under that umbrella term. Also related are challenges and decisions faced by insurers, re-insurers, and their regulators – and which deserve separate treatments.
Hence, a rapidly expanding field in finance is the intersection between technology, sustainability, and finance. This includes an increased focus on environmental liabilities, brown and stranded assets, measurement of carbon emissions, impact on biodiversity, and use of scarce resources such as water. How this translates into new fields of finance is still very much an evolving space, yet key focus areas are emerging, including green bonds, green loans, green listed equity, sustainability-linked products, standardisation of environmental, social, and governance (ESG) disclosures, measurement of environmental liabilities and impact, stress testing of portfolios and exposures, and carbon trading.
Central banks typically play three main roles – bank regulation, monetary policy, and reserve management – all of which are being reframed to incorporate sustainability concerns.
Given the large shifts in asset prices and catastrophic weather-related losses that climate change may cause, regulatory policies are adapting to recognise systemic climate risk – for example, by requiring financial institutions to incorporate climate risk scenarios in their stress tests. Institutions like the European Central Bank, the Bank of England, the Bank of Japan, and the Bank for International Settlements are actively working to repurpose instruments like stress tests and risk-based capital standards – and are considering incentives for banks that offer loans with sustainability objectives.
Some central banks are also looking for ways to integrate sustainability considerations into investment decisions for their own portfolios – which have greatly expanded in response to recent crises. The Bank of England, for instance, is considering how it might support the transition of the British economy to net zero emissions and, as an important first step, is considering how to ‘green’ its Corporate Bond Purchase Scheme. The People’s Bank of China (PBoC) has been evaluating the green finance performance of major financial institutions by looking at green loans and is now also grading financial institutions according to their green bond holdings (share of total assets made up of green bonds and the trend).
Central bank reserve managers are also considering how to incorporate environmental sustainability objectives
The intersections with technologies such as artificial intelligence, the internet of things, and blockchain is particularly exciting in the context of green finance, given the importance of measurement and disclosure for new sustainability-linked products to emerge and for carbon trading markets to scale. However, these are early days and efforts to incorporate climate-related risks into regulatory frameworks face important challenges. Capturing climate risk properly requires assessing it over long horizons and using new methodological approaches so that prudential frameworks adequately reflect real risks. Policies such as allowing financial institutions to hold less capital against debt – simply because the debt is labelled as green – could easily backfire with increased leverage and financial instability that undermine the whole effort.
Finally, central bank reserve managers are also considering how to incorporate environmental sustainability objectives – as part of a significant reframing of what assets are appropriate for reserve portfolios. PBoC has added green bonds to China’s foreign exchange reserves, and a BIS survey found a significant majority of reserve managers expect to consider adding sustainability to their objectives – something unthinkable just a few years ago.
Sustainability as a reserve management objective must be balanced against liquidity, security, and returns. The availability and liquidity of appropriate green financial instruments will pose some constraints in the near term, but even in the medium term, this dynamic could have significant effects on domestic and international financial systems.
Investors, as direct shareholders of large and small corporations, and as stakeholders more indirectly through the demand for financial investment and saving products, are increasingly providing an important ‘green finance’ avenue. While this is also taking place through direct judgments by investors in specific kinds of companies (for instance the share prices of US coal mining companies reflect a ‘carbon discount’), the main impact is through the growing preference for financial instruments labelled ‘ESG’. These instruments have gained much traction, despite the disparity of the objectives and challenges of the three components.
This trend is extremely dynamic. Bloomberg estimates that global ESG assets under management could continue to climb and will represent one third of the projected $140.5 trillion global assets under management by 2025. Although it is hard to disentangle the three components, the ‘E’ in ESG is estimated to account for most of the assets and is also the fastest growing component.
The demand for ESG-labelled assets is raising major questions about how the label is granted and although there seems to have been progress on all three fronts, there is considerable pressure to make improvements. There are several frameworks and standards applied by established third-party ESG rating and reporting agencies. Indicative of how much room there is to further improve the ratings, the correlations between different reporting sources are not as significant as in the case of credit rating agencies, and so considerable (and even retroactive?) changes to rating are expected. Adding to the fluidity of this situation, it is not difficult to imagine that the disparities between the three ESG objectives will result in demand for a more environmentally focused set of ratings and for investment instruments that are more sharply aligned with international climate change agreements and national carbon transition policies.
One financial instrument that combines both green finance avenues (central banks and investors) and provides a useful – although partial – illustration of the dynamics at play is that of green bonds. These bonds are fixed income securities whose proceeds finance new or existing eligible green projects (projects to combat pollution, climate change, or the depletion of biodiversity and natural resources). They are either asset-backed or asset-linked, and issuers must declare the types of green projects eligible to receive funds at issuance.
The momentum in green bond issuance in recent years is estimated by DZ Bank to continue in 2021 and further accelerate in 2022. EU countries have been the largest source of green bonds, the US has been the largest single country source, while international organisations represent a significant share. China is well on its way to becoming an even larger issuer in 2021 – indicative of the rapid dynamics in this market and the recent decision by the PBoC to include green bonds as eligible collateral for its own lending facilities.
A WEF survey from 2020 indicated that only one-third of respondents felt that environmental risks that could affect their business models were being adequately disclosed by companies – and this sounds like a serious wake-up call! While financial regulators repurpose their instruments and reimagine their processes, and the assertiveness of green investor demands is being reformulated, corporations would be wise to keep track of these developments and become fully aware of their environmental assets, footprints, and liabilities. This will affect their access to affordable sources of finance and could be critical in responding to the expectations of key stakeholders.
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